Chapter 11 & 12 Imperfect Competition

1. Chapter 11 & 12 Imperfect Competition • Monopolistic competition • Models of oligopoly • Collusion and theory of games Landsburg, Price Theory and Applications, 7th edition

2. Oligopoly • oligopoly: an industry dominated by a few large sellers who offer similar (e.g. automobiles) or identical (e.g. steel) products. • Since there are only a few sellers in an oligopolistic market, oligopolistic firms are interdependent in pricing and output decisions.

3. Game Theory • Game Theory: the study of how people behave in strategic situations. • By strategic, we mean a situation in which each person, in deciding what actions to take, must consider how others might respond to that action. • Each firm in an oligopoly must act strategically, because its profit not only depends on how much output it produces, but also on how much other firms produce as well.

4. Oligopoly • The all the firm in an oligopolistic market may join together to maximize their combined profit. a. collusion: an agreement among firms in a market about quantities to produce or prices to charge. b. cartel: a formal collusive agreement (e.g. The Organization of Petroleum Exporting Countries).

5. Prisoners’ Dilemma • a game must have • Players : decision makers • Strategies: potential choices that can be made by the players • Payoffs: the outcomes of those strategies •  prisoners’ dilemma: a classic example of "game" between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

6. Prisoner’s Dilemma Landsburg, Price Theory and Applications, 7th edition

7. Prisoner’s Dilemma • Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players. • Nash equilibrium (named after John Nash): a set of strategies, one for each player, such that each player chooses its best strategy given the rival’s anticipated action. No player has incentive to unilaterally deviate from the equilibrium.   Landsburg, Price Theory and Applications, 7th edition

8. Prisoner’s Dilemma • Why is it dilemma? • If they had both remained silent, they would have been better off (with a sentence of only 1 year instead of 8). But, by each pursuing his or her own interests, the two prisoners together reach an outcome that is worse for each of them. • Cooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational. Landsburg, Price Theory and Applications, 7th edition

9. Oligopoly Example of Prisoners’ Dilemma • Two firms with MC=AC=0 & 4 consumers • Consumers will buy from the firm with low price. • Firm will split the market when they charge the same price. Landsburg, Price Theory and Applications, 7th edition

10. Breakdown of Cartels • Price initially set above MC • Without a legally binding agreement, the collusion cannot be stable because each member has a strong incentive to “cheat” by producing more output or charge a lower price. • Analogous to Prisoner’s Dilemma Landsburg, Price Theory and Applications, 7th edition

11. Oligopoly • Bertrand model • Take rivals prices as given • MC and pricing move toward competition • Cournot model • Take rivals output as given • Production level Landsburg, Price Theory and Applications, 7th edition

12. Oligopoly Example of Prisoner’s Dilemma P=100-Q=100-q1-q2 & MC=AC=4 MR1=(100-q2)-2q1 & MR2=(100-q1)-2q2 Profit1= (P-AC)*q1 & Profit2=(P-AC)*q2

13. Oligopoly (Cournot Competition)

14. Mergers • Horizontal integration • Produce same good merge • Ex. Dell, Gateway, and IBM • Vertical integration • Merge so produce inputs used to produce output • Ex. Dell and Intel Landsburg, Price Theory and Applications, 7th edition

15. Horizontal Integration • Reasons to merge • Isolate economies of scale (lower production costs) and capture monopoly power • Competing welfare concerns • Reducing costs and creating monopoly power • Ex. Great American Merger Wave Landsburg, Price Theory and Applications, 7th edition

16. Antitrust Policies Sherman Act of 1890 Clayton Act of 1914 • Prevent mergers tend to reduce competition • Controversy over antitrust criteria • Economic efficiency • US Supreme Court versus European antitrust position Landsburg, Price Theory and Applications, 7th edition

17. Monopolistic Competition • Market where there are many firms selling similar but differentiated products • (e.g. gas stations, restaurant meals, drugs, clothing, and food products) • Characteristics A. Many Sellers B. Differentiated Products: could be an actual physical difference, or just difference in perception (ex: generic vs brand-name medicines) C. Easy Entry into the market in the long run (No barriers to enter)

18. Product Differentiation and Advertising 1. Pro’s a. Variety increases total utility of consumers. b. Innovation leads to new & better products c. Brand names give firms an incentive to maintain high quality, since firms have a financial stake in maintaining the reputation of their brand names. d. Advertising allows people to be more informed about product choices. 

19. Product Differentiation and Advertising  2. Con’s a. Advertising and brand-names may cause consumers to perceive differences that do not really exist. (they manipulate people's tastes.)  b. Advertising lessens price-competition because it increases the perception of product differentiation and fosters brand loyalty.

20. Monopolistic Competition • Long-run equilibrium quantity • Zero Econ Profit (ATC=P>MR=MC) • Welfare aspects • Markup over Marginal Cost • Price > Marginal Cost • Market Output < Social Optimal Output • Excess Capacity • ATC > Minimum of ATC • more variety, more innovations

21. EXHIBIT 11.11 Monopolistic Competition Landsburg, Price Theory and Applications, 7th edition

22. Monopolistic Competition(Monopoly VS Perfect Competition)